The UK government is set to spend 10.4% of total tax revenue paying debt interest in 2023, according to forecasts from Fitch, the credit rating agency.
This would be the highest proportion of revenue spent on debt interest among high-income economies this year. It is also more than twice the amount spent on the armed forces and around two-thirds of the UK’s health budget.
The UK’s high debt interest payments are likely to linger, as there is no policy maker to take responsibility for the government’s longer-term borrowing costs. The two government departments that could do something about this problem are unable to act due to their strict remits.
UK financial regulators cannot address long-term borrowing costs
The first department at fault is the Bank of England (BOE). When the economy was locked down in 2020, the BOE started buying government bonds, the IOUs sold by the government to raise money. By doing this, the BOE raised demand for government bonds and reduced the amount of debt interest the government had to pay. It did this to support private sector borrowing, as many private sector interest rates (such as mortgage rates) are benchmarked to government borrowing costs.
But since inflation began its surprise upswing, the BOE has abandoned its policy of trying to keep long-term interest rates down. Instead, it has started selling the government bonds it holds to raise interest rates and stifle economic activity. It generally does not consider the impact of its decision-making on public sector finances. If it did, it would be seen as having its independence to achieve its inflation targets compromised.
Busy doing nothing
The other government department that could do something but will not, is the Debt Management Office (DMO), which borrows money for the government by selling bonds to investors. The DMO insists it is a price taker rather than a price maker. It follows a policy of selling new debt in equal buckets of short, medium, and long maturities and letting the market set the price for each.
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By GlobalDataThis is unique among developed economy borrowers, which tend to adjust longer-term issuance depending on borrowing costs. If the cost of long-term borrowing is rising, as it has been in the UK, the smart thing to do would be to borrow less long-term debt and more short-term debt. Otherwise, high interest rates are locked in for a long period of time.
UK borrowing is set to rise
There is little co-ordination between the DMO and BOE and both are now planning to add large volumes of government bonds to the market over the coming months.
The DMO plans to sell £138bn ($175bn) of bonds (net of repayments) over the 2023-4 financial year. This already high figure will be compounded by the Bank of England’s bond sales. The Bank is running down its bond holdings at a rate of £80bn a year. This means the UK is adding £224bn to the stock of government bonds from April 2023 to March 2024. This is more than double any previous year’s net sales and long-term borrowing costs are likely to rise as a result.
Because of the DMO’s policy of issuing debt in equal buckets of short, medium, and long maturities, it would not be able to respond to this by, say, issuing more short-term debt.
The BOE could also use other tools rather than selling off bonds. It could, for example, raise capital banks need to hold against their loans, making it more difficult for them to lend. It could even just raise short-term interest rates without selling any bonds at all.
Instead, the UK is planning to borrow more at a time when interest rates are high and is locking in those high interest rates for years to come.
